With the bull run in U.S. stocks likely at an end, many investors can gain from opportunities offshore-after hedging against potential currency losses.
May 1 1994 by A. Gary Shilling
U.S. stocks were the winners in the 1980s. Sooner or later most went up, and the total return for the Standard & Poor’s 500 index rose at a compound 17.5 percent annual rate in the decade. Now, however, U.S. stocks probably have entered a bear market that won’t be the widely expected big buying opportunity, but a Chinese water torture affair that ultimately frustrates investors into submission. Furthermore, for the rest of the decade, the workoff of American economic and financial excesses likely will confine U.S. equities to 6 percent to 8 percent annual growth rates, below the long-term 9 percent to 10 percent pace.
But don’t give up and resign your portfolio to 3 percent CD yields. Money can be made in the remainder of the 1990s, but successful investing will require the use of other markets here and abroad. In recent years, we’ve utilized this approach in the portfolios we manage with more than satisfactory results: In 1993, our limited partnership and flagship account, Thematic Investment Partners, gained 193 percent before fees. Of course, this track record doesn’t indicate future performance.
DEALING WITH DEFLATION
Despite the Fed’s recent interest rate increase to head off inflation, I remain convinced that inflation is a thing of the past. Deflation is now the order of the day. Indeed, global signs of deflation abound: The prices of tangible assets and key commodities have dropped. Wages are falling for many Americans, and U.S. wholesale prices were essentially flat in 1993. Moreover, many longterm global forces promote deflation: the 1980s legacy of sizable debts in all major countries; ongoing job cuts and productivity improvement here and abroad; the unwinding of excess commercial real estate worldwide and continued weakness in U.S. home prices; decreased global military spending; more and better exports from newly industrialized countries such as Thailand and Mexico; and raging protectionism around the world.
In spite of these factors, the surge in the U.S. economy in late 1993 made the Fed fearful of renewed inflation and an ugly boom-bust cycle. The Fed tightening that followed caused bondholders and consumers to worry about inflation and the credit authority’s reaction to it. Consumer spending was responsible for much of the growth in late 1993, but it is unsustainable given consumers’ anemic income growth. Nevertheless, the Fed’s attempt to keep the economy in check could promote one final spending spree. Spooked by fears of rising interest rates, consumers may well race to buy houses and cars, prompting the Fed to intensify its tightening efforts to slow the binge. Down the road, exhausted and debt-laden consumers and considerably higher interest rates will push the economy into a recession, probably before yearend. Hence, the Fed may unwittingly aid my global deflation forecast.
The aftermath of the California earthquake and frigid weather elsewhere during the winter will make it difficult to see the investment landscape clearly for months, but investors should be cautious. However, for those willing to look beyond the intermediate-term effects of the Fed’s tightening, many of our longterm investment themes are attractive, especially in global markets.
COVER YOUR BETS
High-quality bonds win in deflation. A decade ago, when U.S. Treasuries yielded 15 percent, I said they’d reach 4 percent to 5 per: cent as inflation departed. With yields now above 7 percent, we’ve covered much of the ground, but there is still more to go, and exciting bond price appreciation is likely when the economy weakens after the current interest rate spike. I recommend 30-year Treasuries, zero coupon bonds, and bond futures, which will enjoy even more appreciation as rates fall. Longer term, government bonds in Europe will rise in sympathy with Treasuries, perhaps even more so because short-term interest rates there-despite the recent, vicious correction in bond prices-will continue to drop. We plan to go back to U.K., French, German, and Italian government bond futures once the dust settles.
“Futures?” CEOs ask doubtfully. “That’s speculation.” Maybe, but futures do solve one major difficulty with investing abroad: currency risk.
The U.S. has many problems, but Europe‘s are worse. Leaders can’t successfully coordinate EU policies. American firms can easily dispense with surplus labor, while layoffs in Europe require extensive negotiations with governments and unions, followed by large severance checks. Japan needs an economic, political, and financial restructuring that rivals the wrenching 1930s overhaul in the U.S. Lifetime employment, a cherished practice in Japan, must be abandoned. Exports to North America and Europe must be replaced by exports to Asia and internally generated growth. The process on those fronts has hardly begun, and Japan will be the loser if trade differences between the U.S. and Japan erupt into full-scale confrontation.
Thus, the U.S. is the best of the global bunch, and the dollar-the traditional safe haven in a sea of global trouble-will strengthen for years. Without some kind of hedge on foreign investments, you risk giving back in currency translation losses all you gain from success in foreign markets. Futures involve lots of leverage, but that leverage can be managed. And futures on European bonds, for example, largely eliminate the foreign currency risk. You could pay a hank to provide currency hedges, but that is a hefty expense, except for amounts much larger than most CEOs would invest abroad. Some mutual funds hedge their currency exposure, but check carefully; many do not.
Of course, you can go beyond hedging your foreign stock and bond investments from currency exposure. As the dollar strengthens, you can make money in currencies directly. Again using futures, we are short yen and look for a considerable strengthening of the greenback against the Japanese currency. With Japan‘s problems, the trade war-related spike in the yen in recent months doesn’t make sense. We also like the dollar against the European currencies, especially the deutsche mark. Declining interest rates and the lingering recession in Germany-to say nothing of political or even military rumbling to the east-will make the German currency less attractive. Decreasing European interest rates may aid stocks there if a U.S. bear market doesn’t undermine them, but be sure to hedge against a strengthening dollar.
Corporate earnings growth in Europe may be slow as the recessions linger, but as in the U.S., stocks in Europe have been bought by default. Short-term interest rates are unacceptably low, and real estate is an investment no-no, so equities benefit from investors’ zeal for yield. A caveat: Any investment should have more of a push than a pull to be successful, at least in the long run.
Mexico looked good for equities investments long before NAFTA was accepted by Congress. Clearly, both the U.S. and Mexico have wanted to employ American capital and technology south of the border for some time, and including Mexico in NAFTA makes a good situation even better. Remember, though, that rapidly growing, newly industrialized countries, including Mexico, face periodic balance-of-payments crises as growth and inflation get out of hand, giving investors a turbulent ride. In addition, the violence in Chiapas and the recent political turbulence involving the ruling PRI increase our wariness: Such difficulties may make the next president-to be elected this year-somewhat less committed to the sweeping reforms that have bolstered that economy. And renewed recession in the U.S. would reduce demand for Mexican exports.
China is an investor’s dream, but that dream can easily turn into a nightmare. Moving from a command economy to a market economy unleashed the traditional entrepreneurial Chinese spirit. The economy is booming and promises to do so for many years to come, but inflation presents a current and chronic problem for China. The big question: Can the government develop effective monetary and fiscal-policy tools, or will attempts to control inflation doom the economy? Investing in China is tricky. Investors can own the B shares listed on Chinese exchanges, but they will know almost nothing about the companies they own. We prefer Taiwanese stocks as the route to China. Hong Kong stocks, the other road to China, have seen a huge speculative leap as American and other foreign investors have come aboard. However, we advise investors to avoid Hong Kong equities. In fact, you may want to join us in shorting Hong Kong stocks because of their vulnerability and also as a hedge against Taiwan holdings.
We’d also avoid most Latin American stocks outside of Mexico. The long U.S.-Mexican border gives the U.S. special interest in its southern neighbor and fuels a desire to help that economy develop to the point that goods and services-not Mexicans-become its principle exports. The same is not true of other Latin American countries, and a hemispheric free-trade deal is far away.
In early 1988, when the Japanese economy and stocks were still roaring, I wrote a book with a chapter titled, “A Depression Is More Likely in Japan Than in the U.S.” We’ve benefited from shorting Japanese stocks since early 1990 and foresee more downside as the depth of Japan‘s depression, restructuring, and political succession problems becomes clear. But for now, we are on the sidelines until Japan‘s political turmoil quiets down.
International investing isn’t easy. In addition to the global effects of short-term volatility in the U.S. economy and financial markets, investors must deal with unknown foreign markets and currency risks. But just as American CEOs have learned to run their businesses on a worldwide basis, so, too, they must learn to manage their personal portfolios globally. To do otherwise not only will confine them to a potentially dull U.S. stock market for years to come, but will make them miss many profitable opportunities.
A. Gary Shilling is president of Springfield, NJ-based A. Gary Shilling & Co., economic consultants and investment advisers. He is a regular contributor on financial strategy to Forbes.